Brent: Demand Jitters To Drive Slower Start To 2019

We forecast an annual average of USD81.0/bbl for Brent for 2019, with prices trading broadly within the USD75.0-85.0/bbl range

In H1, monthly prices will average towards the lower end of the range, dragged down by slower fuels demand growth and uncertain sentiment in the market, unsteadied by mounting concerns around financial markets and the global economy

We expect to see a run up in prices over H2, as crude demand rallies under the implementation of the IMO’s new sulphur cap and concerns of a supply shortage reemerge

For 2020, we forecast an annual average of USD88.0/bbl, with our data showing a deep deficit in the market, following years of underinvestment in supply

A spike up in prices in 2020 will put extra strain on the global economy and poses significant risks to EM demand in the early 2020s

Oil prices will move towards USD80.0/bbl towards year-end 2018, as markets recover from the recent sell off and participants price in the impact of US sanctions on Iran

*Fitch Solutions is a contributor to the Bloomberg Consensus. Data accurate as of November 1 2018. f = forecast. Source: Bloomberg, Fitch Solutions

Oil came under heavy selling pressure in October. Brent has been caught up in the broader equity rout and the recent sell-off does not, in our view, reflect the fundamentals of the global oil sector. Concerns have built around the late-stage US economic expansion, overvalued US equities, continued rate hikes by the US Federal Reserve and tightening global liquidity. Combined, these set the scene for continued financial market volatility and are likely to pull Brent repeatedly underwater over the coming months.

Global Rout Dragging On Oil

Weekly Change Vs. September 28, %

Source: Bloomberg

One source of financial market risk stems from divergence in the relationship between oil prices and EM FX and equity performance in the YTD. While oil prices (up until September) have trended higher, EM indices have dropped off sharply. The combination of weakening currencies, rising inflation, higher oil prices, tighter financial conditions and dollar debt exposures are stressing a number of emerging markets globally. And, although the crises seen in Argentina and Turkey have not spilled over into broader EM contagion, they illustrate the existing vulnerabilities. From historical perspective, the divergence between oil prices and EM performance looks unsustainable.

Oil, EMs Break Historical Ties

MSCI EM Equity Index & Front Month Brent, USD/bbl

Source: Bloomberg

Brent has also looked vulnerable from a technical perspective. The sell-off over October was aggressive, but has yet to venture into overbought territory. Time spreads collapsed, pushing first-to-second month Brent back into contango and erasing the roll yield. Underscoring the increasingly bearish bias in the market, bullish positioning registered a sharp monthly decline. The ratio of speculative long to short positions in Brent fell from 23.4 to 9.3, driven by both a decrease in long positions and a (sharper) increase in shorts. That said, a softer ratio leaves the market better positioned for reversal, as oil fundamentals regain control over price action.

Bulls Relenting

Managed Money Positions In Brent, Ratio Of Longs To Shorts

Source: Bloomberg, CFTC

On the supply side, the biggest question mark revolves around Iran and the impact and duration of US secondary sanctions. Based on tanker tracking data, Iranian exports averaged above 2.0mnb/d in the first two weeks of October (although they may have fallen subsequently). Under our base case assumptions, these will fall to around 1.2mn b/d under sanctions or, under our high-impact case, 800,000b/d (see ‘Iran Oil Export Scenarios: Supply Risks Acute’, July 6 2018). This suggests significant further volumes have yet to leave the market. However, there are major uncertainties surrounding these scenarios, not least the issue of US waivers.

Exports Have Further To Fall

Iran Crude & Condensate Exports By Destination, '000b/d

Source: Bloomberg

Our base case assumes that the US will extend limited waivers to certain buyers, largely in India and Turkey, and our price forecast rests on this assumption. Under this scenario, India and Turkey will import the maximum volumes available to them, while buyers in Europe, South Korea and Japan will reduce imports to very low or near-zero levels. Companies in these markets – in particular Europe – have heavy exposure to the US and the risks incurred by trading with Iran run too high, even under cover of waivers. China has the greatest capacity to circumvent sanctions and will, we believe, continue importing substantial volumes of Iranian crude, even should waivers be withheld.

As of November 1, reports have emerged that Indian buyers are to be granted waivers to import around 305,000b/d of Iranian crude until March 2019. This aligns closely with our base case, which puts India’s imports at 300,000b/d. That said, the waivers have not been finalised and could easily be derailed by objections from US President Trump. Assuming the reports are accurate, it is not clear whether other buyers will be extended waivers on similar terms, or whether these waivers will be extended past March. Given considerable remaining uncertainties over the shape and impact of US sanctions, our current price forecast may be subject to revision after November 4.

Assuming Iranian exports fall to a range of 0.8-1.2mn b/d, there will be a significant gap in the market left for other producers to fill. Since the decision was taken to begin unwinding the OPEC+ production cut deal, producers – outside of Saudi Arabia – have been pushing their output to its limit. Several markets, including Iraq, Russia and the UAE, have further barrels to add. These barrels alone will not be sufficient to offset the losses from Iran. However, there are a large number of projects rolling on stream in the coming quarters which should prevent too-aggressive a run-up in the price of oil.

These greenfield additions, though, do not represent flexible supply and are vulnerable to any disruption or delay to their start-ups. With the return of barrels from the OPEC+ production cut deal, there is little flexible capacity left in the market. Commercial crude inventories have normalised and, coupled with low global spare capacity, this leaves the market vulnerable to any shocks on the supply side. With unplanned outages historically low – in particular among volatile producers such as Libya and Nigeria – this creates a considerable level of risk.

Outages Shrinking, Risks Skewing To The Upside

Global Unplanned Supply Outages, mn b/d

Source: EIA, Fitch Solutions

In this context, the role of Saudi Arabia as global swing supplier becomes key. The kingdom is currently producing at around 10.7mn b/d and has capacity to raise output as high as 12.5mnb/d, which could comfortably pick up any slack left by Iran. The return of the Manifa oilfield to full production (300,000b/d) and the additional spare capacity from Khurais (250,000b/d) gives Saudi Arabia greater flexibility to raise its output over the coming few months. A restart of fields in the Partitioned Neutral Zone (PNZ) would add further upside, but we have seen little progress in the ongoing negotiations with Kuwait. For 2019 we forecast average crude and condensates production of 11.2mn b/d. This, according to our data, will be sufficient to prevent too sharp a deficit from forming in the market.

We have grown more bearish on the demand side and see rising risks to prices from emergent strains on the global economy. Our global real GDP growth outlook remains positive for 2019, at 3.1% y-o-y. That said, this represents a slowdown from the 3.3% we forecast for 2018. And, according to our economists, downside risks are rising. Growth has been led by the US, while other markets, including the eurozone, have disappointed YTD. The US is late in its economic expansion and there are concerns for its growth as fiscal stimulus begins to wane, inflationary pressures build and the Fed continues to hike interest rates. Tighter dollar liquidity is also challenging growth performance in a number of EMs, pressuring local currencies and raising the spectre of debt.

DM Growth Set To Soften

Real GDP Growth Forecasts, % chg. y-o-y

f = Fitch Solutions forecast. Source: Fitch Solutions

Fuels demand growth has been markedly weaker in the YTD, in both developed and emerging markets. Growth is often volatile and so it’s unclear whether this marks the beginning of a more sustained downturn in demand. The strong growth seen over 2015-2017 was driven by both developed and emerging markets, with DMs reversing years of structural decline, buoyed by low oil prices and firming economic activity. However, in 2018, DM demand ex-US has fallen sharply into negative territory with the United States carrying growth. Eurozone economies are underperforming and higher oil prices are pressuring demand for oil. Should the US economy falter, the prospects for prices will turn decidedly bearish.

US In The Driving Seat

Fuels Demand Growth, % chg. y-o-y, 3MMA

Source: JODI

EM demand has also been slowing in the YTD. Growth has been dragged down by China, while EM demand ex-China continues to strengthen. Chinese consumption is being undercut by decelerating GDP growth, economic restructuring and fuel-switching away from oil. The escalating trade war with the US poses some further risks to growth, although fiscal and monetary stimulus should feed through to the economy next year. Nevertheless, Chinese demand is unlikely to rebound and other EMs are struggling to fill the gap. In 2019, EMs will face a more challenging external environment; added to the pressure from rising oil prices, this underpins our more bearish outlook on demand for fuels. India is supplanting China as the global engine for growth, but cannot replicate the Chinese boom.

China Dragging On EM Growth

Fuels Demand Growth, % chg. y-o-y, 3MMA

Source: JODI

Subsidies remain somewhat of a wildcard for EM demand. During the oil price downturn, emerging markets across the Middle East, Africa, Latin America and Asia enacted fuel subsidy reforms. Consumers have been left exposed to rising oil prices, with local pump prices in a number of markets now higher than they were in 2008. There are insufficient data to quantify the price elasticity of demand in these markets with any high degree of confidence and the task is further complicated by signs of reform slippage in some markets in Latin America and Asia. On balance, though, we expect the impact of reforms to be bearish for both prices and demand.

From 2020, supply-side constraints look set to re-take hold. Natural field declines leave a major gap to be filled, amounting to around 5.0-7.0mn b/d a year, based on historical decline rates. Due to years of underinvestment in the wake of the oil price collapse, the global projects pipeline is rolling off, which puts heavy burden on existing assets. Pockets of greenfield growth will remain, but these alone will be insufficient. Saudi Arabia could help meet the deficit, through fuller deployment of its sizable spare capacity. However, there are a number of factors which will likely limit its production growth.

US shale will remain the major engine of global production growth, but will be unable to keep the market in balance. We hold a bullish outlook on the US, but believe that growth will disappoint the expectations of many market participants. The near-term operational constraints (in particular the pipeline bottlenecks) will be overcome in 2019, but there are also constraints emerging below ground. Much of this relates to increased drilling intensity in core productive areas of the Permian, which is resulting in well interference and declining well productivity. Longer lateral lengths, more frac stages and higher frac intensity are helping buoy productivity, but these have both technical and commercial limitations.

On the demand side, crude looks set for a temporary lift from the implementation of the IMO’s 2020 sulphur cap. The sulphur cap, effective January 1 2020, will prohibit the use of fuels with sulphur content of above 0.5% mass-by-mass. Scrubber installations, which would allow the continued use of high sulphur fuel oil (HSFO), are accelerating rapidly, but from a very low base. When the cap comes into force, scrubber penetration will remain low, at less than 5.0% of the total fleet. Given quality and stability issues surrounding the use of low sulphur fuel oil, ships will be heavily dependent on marine gasoil, as they shift away from non-compliant HSFO over Q419 and 2020. Meeting this demand will likely require a significant run up in refining throughput, inflating the demand for crude, even as fuels demand growth softens. Coinciding with shrinking supply growth, this will likely put significant pressure on Brent heading into the 2020s.